My previous two articles addressed The Perils of ETF Backtesting and the Statistical Basics of ETF Backtesting.

When considering any ETF for your portfolio, one should ask some very simple questions, regardless of the backtesting data.

Does this ETF diversify my portfolio? Does it “plug a hole” that I need to fill? We all don’t need international small cap stocks to sleep well at night. But exposure to different asset classes, namely, large, mid and small cap stocks, bonds, commodities, etc., can help you ride out tough times. The more exotic an ETF concept, the less likely you really need it to obtain decent gains.

Does this ETF magnify positions I currently have? If one were to look in the holdings of the iShares Russell 1000 Value ETF (Ticker: IWD) , one would see holdings such as Exxon Mobile, Procter & Gamble, Altria Group, etc…holdings that are also in the Russell 1000 Growth ETF (Ticker: IWF), albeit not in the same weightings. Keep in mind that whether fundamentally or market cap weighted, many ETFs have similar holdings, which does not help diversification. Take a look under the hood of any ETF to see what is being held, and at the rate holdings are turned over.

Do I understand the ETF? Buying the Rydex Inverse 2 x S&P 500 ETF (Ticker: RSW), which magnifies the return of the S&P inversely 200%, may not be a good idea for your IRA. Understand what the ETF does, if it is a commodity stock ETF, it holds equities the index considers related to the commodity, and the two do not always move in tandem. (In example, take a look at a chart comparing Streettracks Gold ETF (Ticker: GLD) vs. the Van Eck Gold Miners ETF (Ticker:GDX). In short, know what you’re buying.

As far as looking at a backtest for information on possibly purchasing an ETF, Consider these points:

What is the historic Standard Deviation/Sharpe ratio? What is beta? These metrics will tell you what you should expect in regards to price volatility. Going forward, the ETF could experience more or less volatility, depending on market conditions, and regardless of the backtest. Compare these metrics to its benchmark like the S&P 500 (Ticker: SPY). Markets are volatile lately. If the standard deviation is greater than the benchmark, you could be in for a wild ride.

Look at the actual returns: Hard to do if the ETF is new. But compare the actual returns of the fund to the index. Some ETFs experience “tracking error”, whereas it is not possible to completely emulate the index by buying the underlying securities: therefore, the fund management tries to get as close as possible, which can make the returns deviate from the index. Know how far the ETF drifts from its index, especially in regards to returns.

Use common sense. I don’t care what kind of returns real estate ETFS boast in their backtests; Global real estate markets are in a painful decline, and economist forecast that the housing bubble has a long way to go to the downside. Does a 15% annualized return in a backtested real estate index make sense to you going forward? Do some research into the macroeconomic trends an ETF is exposed to. Ask your financial advisor. Read the prospectus. There is a reason why they say “past returns are not a guarantee of future results">

With the plethora of ETFs available only increasing in number, investors must be vigilant to marketing ploys and the lure of strange and supposedly lucrative investment vehicles. While ETFs are excellent diversification tools, they are also created and managed by people who make money off of expense ratios, and the more assets, the merrier. Be aware of statistical marketing and remember the words of John Burroughs: “The lure of the distant and the difficult is deceptive. The great opportunity is where you are.

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